When markets are leaning bullish or bearish, the extent of the shift in sentiment to one side may be predictive of price action that follows in the days ahead. Option traders try to detect the strength of bearish and bullish sentiment by looking at volatility smiles.The volatility smile is simply a graphic of the volatility surface. It reflects an imbalance in the implied volatilities of an option at the same strike price. Either the implied volatility of puts at the same strike price is greater than the implied volatility of calls at that strike price or vice-versa.
If the market crowd were neutral in regard to direction,there would be no skew. It would be a perfect smile! The more experienced binary option traders may want to use volatility smiles to see which way the market is leaning. It provides more evidence, not necessarily where the market will go, but where the opinion pool is clustering.When the volatility smile is extremely skewed to puts or calls, it can be interpreted as confirming a strategy to follow the skew.
Alternatively, it can also be interpreted as representing an exaggerated condition and a reversal is coming. On its own, a volatility smile cannot be used as the only source of a confirmation on direction. It’s also important to locate the volatility smile for weekly or one-month durations as its relevance to binary option decisions declines when the smiles are using longer-term time frames.An effective way to apply volatility smiles to binary option trading is to evaluate the presence of a smile or a skew as a way of confirming the mood of the market.
Then compare the results of the review with your own opinion.Is your binary option bet going with the skew or betting that it will reverse?Let’s look at a snapshot of some volatility smiles and relate them to the mood of the market at that time.The EUR/USD on May 30 showed a volatility smile that is leaning to the put side.The AUD/USD pair shows a very steep bias to puts. This would make a binary trader think twice about going long the AUD/USD.
An appropriate strategy when the volatility smile is skewed so far is to go with the crowd with a deep-in-the-money strategy .The GBP/USD volatility smile also shows, compared to the AUD/USD,a steeper lean to the put side . The USD/CHF volatility smile here is interesting because it shows, in contrast to the EUR/USD , a bit more of a sentiment for calls, but still very bearish.
The USD/CAD pair is the only one of the majors that has a smile that is favoring the call side, showing a very strong bias for a stronger dollar . Traders looking for a stronger Canadian dollar because of stronger oil would think twice about it.The USD/JPY volatility smile was almost the only one close to being balanced and showing a normal smile . This correlates with a sideways action and, in fact, a normal smile supports a breakout strategy since the market is not showing any domination regarding direction.Our last volatility smile is the GBP/JPY cross pair.
We see a very strong preference for a weakening of this pair. Once again seeing this, the choice facing the trading is to either be contrarian and go the other way, or join the crowd .The difficulty with volatility smiles is that it takes special software offered by third parties to generate the visuals. They are, however, available for the more sophisticated trader through special software and applications. Also, the more quant-oriented traders can generate their own volatility smiles from grabbing option data from the web. In any case, traders who access volatility smiles will find it a useful tool to gain an edge.